Troubled Assets: The Untried Remedy
by Michael S. Rozeff
by Michael S. Rozeff
The central problem of the current financial difficulties is troubled assets. These are loans whose value has fallen sharply. The loans are owned or held by financial firms such as banks, insurance companies, mortgage lenders, broker-dealers, hedge funds, mutual funds, pension plans, and investment bankers.
When the loan values fell, there were many effects, a few of which will be mentioned. Many firms became insolvent, that is, the value of their assets fell below the value of their liabilities plus equity. They continued to operate but their bankruptcy risk rose. Some highly-levered firms that had excessive liabilities ran out of cash and failed altogether. The banks in shaky condition retrenched and became less willing to make new loans. They became less willing to make loans to each other, as they were unsure of the credit-worthiness of other bank borrowers. These effects showed up in financial markets. Interest rates on risky debts rose sharply. This is the same as saying that their values fell sharply. The costs of insuring against debt default rose sharply.
Yet, with all of this, loan growth remained high and positive. There is, so far, only a lower but still substantially positive growth rate of loans. Commercial and industrial loans at all commercial banks was $1.60 trillion on 10/1/2008 compared with $1.39 trillion on 10/1/2007. Consumer loans over the same period have risen from $788.5 billion to $869.3 billion. Real estate loans have risen from $3.54 trillion to $3.79 trillion.
These figures, of course, may partly reflect actions taken by the government, whose impact we do not know. (By government I mean government officials.) Yet I think that careful analysis will show that before these actions could have had any effect, the loan growth slowdown was not at all unusual or out of keeping with past recessionary periods. The main reason for the label of crisis in this case is that, prior to this slowdown, the loan growth had remained at extremely high rates for an extended period. They had been 10—12 percent per year for three solid years, 2005—2007 and even into 2008. In prior episodes, growth rates of loans had spiked up and down above 10 percent rather briefly. What this means is that after 2005, a great volume of loans had been extended. Debt had risen by 30—40 percent in only a few years. Hence, when the slowdown occurred, the wealth losses have been very large.
Reportedly, the markets in these loans and debts tended to freeze up or become clogged. This means that the number of transactions declined. There are always willing buyers at a price and willing sellers at a price, but apparently they are not meeting in the marketplace to exchange. Why not? (1) The previous volume was so large that it is hard to find buyers willing to take these loans off the hands of the financial institutions that want to sell, without large price concessions. (2) The loans were placed so widely throughout the system that wealth has been destroyed pervasively. New buyers are not growing on trees. (3) Some banks are unwilling to sell their troubled assets at the low bid prices. If they do, they will book a loss. Their capital will fall below required levels and they will face regulatory measures to restore capital. (4) Some sellers do not want to sell at what they view as distress prices. Their assets are illiquid and buyers aren't willing to pay the asked price, but the sellers believe the assets are worth more. If they can survive and hold on without selling, they will. (5) Some sellers look to be bailed out by government relief programs. They see no need to sell troubled assets at low prices if they can muddle through with government aid. (6) The buyers themselves are not always in a position to buy the troubled assets. Many have over-borrowed and are suffering losses. (7) It is not clear when a price recovery might ensue. Some intrepid early buyers of troubled assets under-estimated the problems and suffered losses.
The government solution
Over the past year or so, the U.S. government responded to the crisis with a long list of very expensive measures. The U.S. Treasury and the Federal Reserve began many programs that they thought would end the financial crisis. Governments overseas have done likewise.
The objectives have been variously described as unclogging the system, getting the markets to work, unfreezing the assets (the troubled loans), rebuilding confidence and trust, reducing systemic risk, restoring liquidity, and preventing systemic collapse, etc.
In reality, the proximate objective is to bail out the banks, especially the larger banks. The main private sector beneficiaries of the government policies are those who have made loans to banks in excess of insured deposits and the bank managements. Shareholders have obtained some benefits as well, even as equity values have plunged.
At times the officials said that they wished to restore lending. This rationale is hard to square with the fact that loan growth is still positive at a decent rate in excess of 5 percent per year. Political forces are in play to satisfy various Congressional demands that want a return to the high loan growth rates of the past. Congress does not want to face the unhappy interest groups and campaign contributors whose livelihoods are affected by the slowdown. Most recently, for example, the Fed announced yet another gigantic loan program worth $800 billion. The Fed will buy mortgage-backed assets (debts) from Fannie Mae and Freddie Mac, the two mortgage intermediaries already bailed out by the government. The Fed will also buy car and student loans.
The deeper government objective is to maintain its own size and power. The government is providing corporate welfare to banks and other financial institutions only because they are a crucial component of the existing economy that provides the government with its revenues. The government has no particular love affair with banks (or with Americans for that matter). The government prefers to continue at its current size with the least possible difficulty and with the least risk of eventually being constrained from growing. To maintain its size and power, the government cannot contemplate any serious interruption in its revenues that is extended for years on end. Additional factors shaping government actions are that the campaign contributions of financial institutions are very large, and that the Fed is an agency that is designed to further the interests of the member banks, especially the larger and more influential ones.
It is the government's quest for its own survival that is paramount to government. The government would have vastly preferred that this crisis would not have happened, inasmuch as it threatens its own viability and freedom of violent action. There are many measures that the government could have enacted that would have quickly alleviated the problem of troubled assets, but they were not enacted because they would have altered the existing system in a fundamental way that would have threatened the existing power structure. Instead the government chose far more ineffective, costly, and inefficient means that, in its calculus, resolve enough of the problem while keeping government intact and even expanding its power. The government has used the crisis to its own advantage.
When an official of government talks about healing or in any way aiding the economy, he is not talking about a market economy, for a market economy, among other things, is an outcome or a resultant of innumerable free human actions. Only freely-acting persons can heal a nonmarket economy that has been wrecked by government. To government officials, such terms as "healing" and protecting and preventing systemic risk mean maintenance of the existing nonmarket system. It means keeping their own intervention in markets alive and well. It does not mean what health means in a free market economy, which is that each person is able and encouraged to realize his own talents, creativity, and skills through peaceful associations with others; and that each person is able to direct the benefits of his productivity where he chooses.
The deceptive rhetoric
Government officials first and foremost act on their own behalf, which means they act to preserve and augment the government and its powers. They fool us with their tricky rhetoric.
Robert Rubin provides a good example of official rhetoric. Only trivial differences in language and emphasis separate his basic thinking from the likes of Lawrence Summers, Henry Paulson, and Ben Bernanke. They all believe in government and not in free markets.
Robert Rubin: "I think the single most important thing we can do right now is a very large fiscal stimulus married with a commitment once the economy is healthy again to put in place a multiyear program to get back to a sound fiscal regime." (November 24, Wall Street Journal.)
Mr. Rubin sees only one economy, the economy that now exists. He reveals to us no deeper vision or understanding of an economy. Von Mises made it clear that the free market economy is one in which government does not hinder or encroach upon the private ownership of the means of production and, in theory, protects the freedom of the markets. By contrast, in the nonmarket economy, the government coerces and compels as it interferes in markets. Rubin does not distinguish the pure or unhampered market economy (to use the terms of von Mises) from the nonmarket economy.
If Mr. Rubin believed in a market economy, he would tell us something radically different. He would tell us that the single most important thing we can do right now is reduce government compulsion, protect private property, and move toward a free market economy. He would be anxious to move us away from an undesirable state of affairs, a nonmarket economy, to a more desirable one, a market economy. Instead, Rubin approves of the heavy-handed moves of the Treasury and the Fed in the past year: "I think the financial system is in better shape today than it was before Hank [Paulson] and the people at the Fed acted in the various ways they acted."
Mr. Rubin not only believes in the existing nonmarket economy, but he welcomes government actions that make it even more of a nonmarket economy. He prefers government and non-freedom to free markets and freedom.
But Rubin's rhetoric is very tricky because he speaks of free markets as a good thing. Having just got done applauding massive Treasury and Fed actions, he turns right around and says: "But we also have a market-based financial system, and I think that is the most effective way for our economy and for the American people to have the financial system organized." Rubin simultaneously suggests that free markets are not entirely a good thing. He does this in order to rationalize government interference: "So it seems to me that you have to find the optimum balance between increasing [government] protections against risk and maintaining the benefits of market-based systems..." Rubin here speaks like a social engineer, for only a social engineer's flight of fancy imagines being able to aggregate and measure these supposed benefits and costs across an entire economy in order to strive for an optimum balance.
Where is Rubin's heart and spirit? It is not with freedom and free markets. In the Hamiltonian tradition, it is with government. He distrusts free markets. He distrusts freedom. Government officials today, Democrat and Republican alike, are, by and large, conservatives in the Hamilton vein. They are like the Federalists of old who believed in strong central government and who were decidedly anti-liberal. They shade over into fascists and socialists.
Men like Rubin deceive. They sell government as a good that balances the supposed bads of the free market. The political parallel is selling republicanism and a centralizing Constitution as a bulwark against rabble-rousing and destructive democracy. In both cases, the idea is to justify the power of government officials.
There are stark contradictions and deficiencies in these rationales. Why is it that Robert Rubin as free market investment banker and as Citigroup leader badly protects his interests and that of his companies against risks, but as a government official he protects those same interests so wonderfully? If there are millions of companies facing millions of risks that change by the minute, how do Robert Rubin and a few officials far from the action acquire such superior knowledge that they better control risks? How can a free market company be relied upon to produce and distribute more and better products in a timely way, which is what Rubin applauds, while at the same time not be relied upon to understand and control the risks it faces in the marketplace? How can this be when the production and distribution decisions cannot be divorced from assessments of risk? Why can we expect government officials to look out for our interests and not their own? What possible reason do we have to trust government officials?
The untried remedy
My intent here is the narrow one of addressing the problem of troubled assets, not outlining an extensive program of monetary freedom or a new money and banking system.
To facilitate the movement of troubled assets from the hands of banks to the hands of investors, what is needed are new and free asset markets: one or more e-bays or NASDAQs or exchanges that deal in these assets. There are many entrepreneurs who are willing to start dealing in these loans. They are willing to make a market, to quote bid prices and ask prices, to set up the machinery of transfer and exchange, and thus to bring buyers and sellers together. What prevents this from happening? In a word, regulations: government regulations and red tape.
The remedy for the troubled asset problem is complete and thorough-going deregulation of exchanges and market-making of securities. The business needs to be opened up and freed from the excessive burdens of government regulation. Any person should have the freedom to enter this business. This will never happen. The government would prefer to see the economy crumble first, rather than give up its powers. If the economy crumbles, any number of officials and former officials stand ready to organize and jump in (and re-constitute a new government if need be) with new and renewed powers.
Government has spurned the obvious and untried free market remedy and instead has chosen measures that enhance its own standing. It did not move in the direction of a private market solution. This would mean, among other things, repealing such measures as the Securities Exchange Act of 1934.
As matters now stand, the Treasury and the Fed have completely preempted the free market solution. They are setting prices for troubled assets. The Treasury intends to buy them and then auction them off with taxpayer funds and with Federal Reserve loans. It is building the organization to do this. We can expect inefficiency, slowness, political issues, and losses to the taxpayers out of this.
As for the Fed's role, we can expect greater rises in prices, which is a loss in the dollar's value. We can expect far worse than this. If the previous Fed tightening was enough to have collapsed the price structure and caused the large wealth declines we have seen, what will happen when the Fed in the future unwinds the debt structure that it is now building up? The dollar faces a dilemma. If the Fed unwinds the new debt it is creating, a big depression occurs that is even worse than this one. If it does not unwind, then a big inflation occurs that is then followed by dollar destruction. In either case, the income, wealth, and well-being of Americans are destroyed.
Our officials not only believe in government, but they also believe in their own power to avert the coming economic catastrophe. Lawrence Summers, who is a top official in the Obama administration, echoes Robert Rubin. He wants a massive increase in fiscal deficits over the next several years linked to fiscal responsibility (cutbacks) thereafter. To expect Congress to behave in this way is naïve at best and deceptive at worst. Narrow technicians in one field, such as economics or law, who are true believers in government and Keynesian remedies and who spurn free markets, cannot provide the enlightened political leadership that Americans need to avoid the destruction that lies ahead.
November 29, 2008
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
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